The short end of the long / short ratio has been much maligned. In July, for instance, short shorts subtracted -5.1% from hedge fund performance, according to a Morgan Stanley Prime Brokerage report out Thursday. Five of the last six months the short end of the long / short ratio was negative.  But while longs have outperformed, the contribution of short alpha has been under-represented in performance attribution. Don’t be dissuaded by poor recent performance, “short alpha might start looking better” the Prime Brokerage report concluded in a report titled “Reconsidering Shorts: More Alpha than Meets the Eye?”.

Also see top hedge fund letters from Q2 2016 

With stocks on a stimulus-fueled run higher, short alpha is difficult to come by

The short exposure in the long / short ratio has always been the most problematic for relative value equity strategies. Stretching back to 2010, nearly 80% of total alpha was generated on the long side, while short exposure only delivered 20%, a Thursday Morgan Stanley Prime Brokerage research piece noted.

With stocks rising much more often than they fall across time frames, short alpha has traditionally been a prized hedge fund attribute. This is particularly true in an environment where quantitative stimulus has had an indiscriminate effect of lifting all stocks higher.

But don’t despair. The Morgan Stanley Hedge Fund Thought Piece asks an important question in the title: “Reconsidering Shorts: More Alpha than Meets the Eye?” Due to certain technical issues, short alpha may appear worse than it really is, is the message.

Geographic exposure impacts long / short ratios

Geographic region has a reasonably important impact on short alpha. The US, where the stock market has generally run higher, is a location where long exposure outperformed the MSCI North American benchmark index by 36% since 2010. The problem is that during this period of time, short exposure underperformed by 24%.

Over time the ratios have changed and a current trend is emerging.

“While longs have clearly done better over time and shorts have mostly done better recently, the alpha split (pie chart) shows that 40% of the total alpha has come from shorts, which is double the amount at the global level,” the report from John Schlegel, Anne McNerney and Vasileios Prassas observed.

Performance varies around the world

Across the developed world, the picture becomes more nuanced.

In Europe, for instance, long exposure outperformed by 51% and shorts underperformed by 35% and in Asia that spread was 52% to 40% respectively.

Looking at disparities in the numbers, the report notes that hedge funds have been overweight North American shares on both sides of their long and short books at a time when the US dollar has outperformed.

This has created an illusion of sorts. “Being overweight the region that has outperformed helped long alpha appear better, but has made short alpha appear worse.”

The report notes that being long and short in North America boosted the global average by 15% to the positive on the long side and 9% negative on the short side. Add in a currency effect, and long performance was boosted by 7% while the short end of the book lost 6% as a result.

Adjusting for the nativist impacts on performance, the real short alpha contribution increases by 26%.

Long / short exposure is viewed vary differently depending on the hedge fund

Separate analysis considers that, from one standpoint, the long / short ratio is a theoretical battle ground. Some hedge fund managers, such as William Ackman at Pershing Square, view short exposure mostly from the standpoint of alpha generation. The thesis to short Herbalife had nothing to do with portfolio balance or a long short ratio, but rather it was entirely due to the fact he thought the stock would move lower due to their business practices.

A source close to the fund once said the long / short ratio or macro considerations are not a concern. It is all about individual alpha. Ackman is not alone in this regard – and there is no right or wrong, just different schools of thought.

This contrasts with the long / short management approach of Joel Greenblatt and Gotham Asset Management, which generally does not alter the long / short ratio based on macro environmental analysis. Rather, a mandated portfolio formula has historically determined the ratio, which is closer to an even split between long and short. Historically, equity hedge funds were much more long than short.

Contrast this with Balyasny Asset Management to see a diversity of thought on the long / short ratio management concept. They not only look for individual stocks that are weak to potentially short, but they also consider likely macro factors that might impact performance and dial up and down the ratio. In effect, the short end of the long / short ratio is used as a buffer for performance.

And it is here the Morgan Stanley report comes back into focus, which puts the long / short ratio into perspective:

If long and short alpha is positively correlated, then it can suggest there will be very good periods for HFs and some very bad periods. However, if shorts perform well when longs don’t, then they can provide a cushion to the long side and help smooth out total alpha over time. The global data (original data with N. America overweight included) suggests that there have been periods when short alpha has done well when longs have lagged. In the cases of 2H15 and 2H11, the positive short alpha ALSO came when markets rolled over.

In other words, while it might be easy to disparage short exposure, it is not always wise.